Forming An S-Corporation To Reduce Self-Employment Taxes

Now that I’ve mentioned tax avoidance, one potential advantage of incorporating your business into an S-Corporation is the ability to reduce the Social Security and Medicare taxes that you pay. I’m going to stick to using examples of one-person businesses.

Simple Example
Here is a simple example. Let’s say you have two self-employed people, Sam and Carrie, who are both freelance photographers. Their businesses make the same net profits of $60,000 last year ($5,000/month). The only difference is that Sam is a Sole Proprietorship and Carrie is an S-Corporation.

Because Sam is a sole proprietorship, there is no difference between him and the business. They are one and the same. Therefore he has to pay self-employment taxes (Social Security + Medicare) of 15.3% on the entire $60,000 annual net profit, or about $9,200. He also must pay federal and local income taxes on that income.

Carrie is a bit different. She incorporated her one-person business into an S-Corporation, which is a separate entity. She wears two hats: she is the sole shareholder of that corporation, and also the sole employee.

S-Corporation are a ‘pass-through’ entity, which means all the profits of the corporation pass through directly to the shareholders’ tax returns. S-Corps do not pay corporate income taxes. However, the classification of this profit also matters:

As an employee, she just assigns herself a “reasonable salary” as required by the IRS. She does some research, and finds that similar photographers in her area earn $25 an hour. $25 an hour x 40 hours a week = $1000/week, or $4,000/month. So her salary is $4,000/month.

As the corporation shareholder, she owns a business with $5,000 of overall profits each month, but also pays out $4,000 for that one extremely loyal employee. That means $1,000 per month is not paid out as salary, and will be distributed to the shareholders (her) as dividends, or unearned income.

At tax time, Carrie gets $48,000 a year in earned income as an employee, and $12,000 in S-Corp distributions as a shareholder. You only pay self-employment taxes on earned income. $48,000 x 15.3% = $7,400. She also must pay federal and local income taxes, the same amount as Sam.

So as an S-Corporation, Carrie paid $1,800 a year less than Sam in taxes.

Famous Example
The most famous example is ex-VP candidate John Edwards, who formed an S-Corporation to reduce taxes on his significant earnings as a trial lawyer.

His S-Corp earned from $5-11 million dollars a year from 1995-1998. His stated salary? A mere $360,000. Here is a New York Times article about it. Note that even in this extreme case where he saved over half a million dollars in payroll taxes, it was not found illegal:

…But even those whose business it is to collect taxes said they could find no fault with what Mr. Edwards did. “Let’s face it,” said Veranda Smith, a government affairs associate with the Federation of Tax Administrators. “I work for the state tax agencies, and I’m perfectly happy to say that anyone who puts in a structure that pays more taxes than necessary is nuts.”

Wow!
Basically, you are saving self-employment taxes on whatever profits are not counted as salary. In the past (and also in the present), aggressive business owners have tried to take all their income as dividends and receive zero salary, but the IRS has been cracking down on this. (Can you say audit flag?!)

As you can see, the benefit can be really significant as overall net profit increases. The difference between $90k salary vs. $50k salary/$40k dividends is $6,000 a year in savings. Remember, you have the right to structure your business to minimize taxes. Detractors may call it a ‘loophole’, but the fact is it is available to you now. For how long? Who knows.

The main hurdle with this strategy is that the IRS gives basically no guidance as to what is a “reasonable” salary. From the case studies that I have read, the IRS does not want to be in the position to decide what people ‘should’ earn. People who have good substantation of why they chose the salary they did have passed through audits successfully. People who didn’t and took unreasonably low salaries got their dividends recharacterized as earned income, and got charged back-taxes and penalties.

I am personally going to use Salary.com and similar data from other job sites in my area to form my salary numbers. I have met with tax attorneys and they also do not give firm guidance. They do however recommend against giving yourself zero salary.
Some CPAs use the “60/40 rule”, which says that your salary should be no less than 60% of the net profit, allowing the other 40% to be distributions. This is more of an anecdotal rule from what I have read, and has no basis from any IRS source or hard evidence that I am aware of.

I should also note that if you pay less in Social Security taxes, this may affect your future Social Security earnings in the future, as your salary is seen as lower. However, if you’re like me, you’d much rather take the money now as opposed to hoping to get it back 40 years from now.

Of course, the possible tax benefits must also be weighed against the cost of forming and maintaining corporation status, including the extra paperwork involved. If trying to save money, you can file for a corporation yourself or use a legal service like LegalZoom and others.

Keep in mind this is all based on information I gathered from the internet, tax books, and consultations with CPAs and tax attorneys. I am not a tax professional and this is not tax advice. This post also excludes many of the other advantages and disadvantages of S-Corporations over other business forms such as Sole Proprietorships, LLCs, or C-Corporations.

Comments

IMHO, considering Social Security is either going bankrupt in a few years or have benefits dramatically reduced, paying less into Social Security would be a good thing. Assuming, that is, the extra money is put into a Roth or other retirement account. At least you have a better chance of seeing your money again, and likely have a better rate of return than Social Security.

Remember that there is a cap on the social security that must be paid. The benefits diminish quite a bit once the salary exceeds 90k as the social security portion has a cap whereas the medicare portion does not. The biggest benefit of course is the deductions.

Hi
Great site! Just wanted to give my two cents on S-corps. Great vehicle for small businesses since a lot of small business owners use the BUSINESS account as their personal checkbook. The “personal” transactions can be reclassed a “S” Corp Distrubtions. While this increases your profit (not deducted as an expense), you don’t committ tax fraud.

But just to let you guys know that the IRS will reclass your “S” Corp Distributions subject to “SE TAX” if you don’t take a reasonable salary! What i advise my clients to do is pay yourself the social security max and the rest as “S” corp distributions.

For a lot of people this may be to much work, then a LLC is better for you. All LLC earnings are subject to SE Tax and income tax where as an S Corp is subject to only income tax!

I am not quite sure if a $1,800 savings on the S corp vs. sole proprietorship is really that worth awhile. First, you will still have to pay a range of small taxes such as franchise tax each year. Depending on the state, that amount can be easily $500-$1000. Then there’s a bunch of orgnizational overhead that you need to take care of on a S corp. Even though the complexity on a S corp is significantly smaller than that of C corp, it is still an corporation. One alternative to S corp is LLC. I think when you only have yourself as the owner and employee of the company, there’s really no need to incorperate. I would form a S corp only: 1- I have at least one other serious partner that’s not my wife, and 2- I have potential investors down the road that may be interested to buy some shares from my business. For some freelance consulting works that may or may not take off as a full time business, LLC is probably more efficient and effective.

Quick comment on LLCs – with an LLC, you can elect to be taxed as a Sole Prop, S-Corp or C-Corp. I have an LLC and just choose the S-Corp election, so I can save on SE tax. The paperwork is VERY easy compared to a traditional S-Corp, plus I get the tax benefit.

A poster claimed that LLCs have to pay SE taxes on all income, that is incorrect, as long as you notify the IRS that you intend to file your taxes for your LLC as an S-corp, you’re fine. I doubled checked with this with both the IRS AND my Tax Accountant.

Another nice tax advantage is being able to make a large contribution to a retirement plan that can dwarf the $15k 401k contribution limit.

If you have a SEP IRA you can contribute up to 25% of your compensation ($44k max) for the 2006 tax year. If you have a solo 401k you can contribute up to 25% of compensation ($44k max) as a profit sharing portion in addition to the $15k max payroll deduction.

Great thoughts. I too formed an S-corp and have been happy with the tax situation so far. Of course, I’ve not turned a profit as of yet, but the ability to write off expenses is wonderful (not specific to a S-corp).

Forming the company was easy, I did it all online and without a lawyer…

Very interesting discussion. I wonder if there is great advantage with a C Corporation:

For instance:

1. Dividends are at the dividend tax rate of 15% vs. 28-36%.
2. Your corporation is more cleanly separated from your own finances per nick’s comment – harder to pierce the corprate veil.
3. Corporate C income taxes are often much lower than individual income taxes up to about $50,000 (I think – may have changed).

I thought about the LLC taxed as S-Corp election, but since that option has been only available since 1997 (and supposedly not officially ‘blessed’ as okay by the IRS until 2001) not many people know about it and there isn’t much documentation about it either. There was really no difference in cost for me, other than extra paperwork, so I chose the S-Corp. Later on, I can still merge into a LLC if I really want to.

It’s a good suggestion though, people considering S-Corps should also look into LLCs, which can be taxed as C-Corps or S-Corps if they want.

To follow up on your email. You are incorrect. An corp or an s corp is a corporation for legal and tax purposes..A LLC is a parternship for tax purposes unless you are a 1 memember llc and you file your taxes as a sole-prop. There is no option to go back and fourth since one entity is a corporation and the other a partnership.

Jonathan posted a great article. Even though I work for myself, I am a S-Corp and get a W-2 paycheck every month (to offset SE taxes) and to minimize my tax exposure. It is true that a single-member LLC is easier to start & manage but you should really consult a tax professional before you commit to the proper tax entity. For instance, an S-Corp is subject to different STATE taxes than a LLC in California. Do your research and CONFIRM your decision with a tax professional. Understand the long-term consequences of your legal structure.

For example, if you are selling your business, the worst possible legal entity (in terms tax exposure) is a C-Corp. I have recommended to ALL of my clients to RUN (not walk) but RUN to your CPA/tax attorney to change your structure ASAP. This issue is pretty difficult to explain here in a single post. Just remember that minimizing taxes is only ONE factor in selecting the right legal entity for your business.

This is a great discussion. I think it all depends on your job situation and how your business generates income. I’m a self employed anesthesiologist doing per diem work. Since I’m single, with no kids, don’t currently do my own billing, the Sole Prop. was the way to go.

I think if you have a partner (or wife or kids, retired parents whom you can put on the payroll), than the S corp is the way to do. My ex med school roommate put his wife on the payroll and basically put away 42K (total of 84K in pretax deductions) in both their SEP accounts last year. So partners have a major tax adavantage.

FYI, I think if your income is less than 200K, the solo 401K is a great way to maximize your retirement contributions. However, in higher income brackets, the SEP is the best/easiest way to go.

The lame thing about the Scorp is that you have to start running payroll and things like that – a whole other headache by itself. Don’t you then have to worry about withholdings and unemployment tax and all of that?

Even with the so-called “double taxation” of C-corps there are still many valid reasons to choose that status over a S-corp. There is no one size fits all in the world of entity selection; it comes down to the unique circumstances of the individual and business. For a bit more coverage check out:

Just wanted to back up Mark’s comments.
I have an LLC which I elected to have taxed as an S-Corp.
As he mentioned, the paperwork is easier, but the tax benefits are the same.

In addition, I would add that paying unemployment taxes and dealing with the payroll/witholding issues are really not that much of a headache. If you are in an industry or situation where you cannot accurately predict your income you have the option of simply paying it all at once at the end of the year – as opposed to doing it quarterly.

I simply fill out my unemployment reports showing I have made zero profit for the first 3 quarters of the year. I happen to be able to do this because my work is seasonal… so your mileage may vary.

I’m at the end of my first year as an S-Corp and I’m still not sure about how much taxes do I pay on my profit (btw. I do have an accountant. I just doing some planning.) Carrie made 12K in profit. However, you didn’t show what she paid in taxes on that 12K.

Let’s say you make 110K at your “day” job and accept a side job as a consultant. They offer you 50/hr W2 or 60/hr 1099/C2C. Since you personally are already maxing out the Social Security tax does this change the thinking on what to do (start a biz or just go W2 for simplicity)? Additionally – if your partner makes another 105k at her day job maybe start an S corp is the way to go with SEP? The goal of the side job would mainly be to try to build up a bigger nest egg for retirement anyway.

one cannot compare the advantages of LLC versus S-corp. the LLC is a state defined entity. the S-corp is an federal defined entity. an LLC can be a sole proprietor, a partnership, an S corp, or a C corp, depending on circumstances and elections. so there is no way to compare.

someone mentioned unemployment taxes as a consideration. they are immaterial to a single employee S-corp.

someone else mentioned that there was not enough track record on the LLC being treated as an S-corp. the IRS has fully recognized that the LLC can be elected as an S-corp with no adverse ramifications.

Has anyone looked into S Corp and medical plans. What I’m thinking of doing is create an S Corp with myself as the sole owner, hiring my wife as an employee and providing her with medical benefits for her and her family (which includes me). This is legal as a sole proprietorship, but I haven’t seen it discussed for S Corps.

I love how those pointing out that the examples conveniently “forget” that one still has to pay taxes on the unearned dividends are being ignored. When you take into account the additional taxes for the unearned dividends, plus the extra work of payroll, plus the extra taxes for things like unemployment, there really is no TAX benefit to being an S-corp. Rather you are really only looking at a liability benefit. The Taxes will be roughly the same. The $12,000 extra in the original post will be taxed too.
Anonymous said it on 7/9/2006;
Anthony said it on 12/31/2007 and now I’m saying it on 10/18/2007.

Hi, Great article, but I have a question (maybe I’m missing something). I ran my first payroll as an s-corp (single owner/employee). I see that after adding up the amount withheld from my paycheck, as well as the matching amount the company pays (which is, me) for ss and medicare add up to about 15% percent anyway, so how is this any different from paying self employment taxes of 15% when I take distributions?

Mike, the rest of the earnings that you take out as distributions are not subject to SE tax. Your savings will depend on your business and what the difference is between your reasonable salary and what your company’s gross revenues are.

You do have to fiddle with the payroll tax returns, W-2’s, etc but at least you don’t have to worry about paying quarterly estimated taxes anymore since you can show enough federal and state withholding on your W-2 to cover whatever taxes you may owe.

So, my husband just formed an S-Corp last year. I understand the value in the example above. However our accountant has us still paying Estimated Quarterly Taxes around $4K (4X’s a year) as well as Monthly Payroll Taxes of $1K a month. He takes $2K for his salary monthly.

Can you explain Payroll Taxes in more detail? How should I go about doing them? I hear they are very complicated. Also, what about the situation where your income can vary a lot through the year. If I bounce around from contract to contract through the year and may suffer dry spells, are Payroll taxes flexible enough to deal with this, particularly in those times where there is no income coming in?

Folokun,
I have exactly the same situation as you do. Do I need to pay myself from s corp on w2 basis. My day job is already paying me on w2. Is it legal to take only k1 from my s corp? The Salary I am getting from my employer ( other than my s corp ) is the only source of my w2 income at this time where I maxed out my social security tax. Also how do I get state tax credit for electric car which I bought it in the name of my business. I only issue k1, where I don’t pay taxes for my business. Please advice.
Ynomani @yahoo.com

I just went through with this for 2008, I was a single member llc, and hated the SE tax however looking into being taxes as an s corp would save me a few thousand, but nothing crazy and this because of one thing.

So what is the process of switching from LLC to S Corp because the state of California also assess a $11,000+ annual fee based on gross revenue just for doing business in the state – whether you make money or not!!! It’s ridiculous

screw the IRS!!! they are corporate leaches sent to gratify politicians as more than 50% of our tax money has been shown to go towards private use!!!! those of us who own business aim to duck them like bullets and every few years they devise some new form of chomping into what you have created. once we think we have figured out how to indulge the fruits of our labor we get the full basket stolen? ohhhh mannn!!!! tax FREE AMERICA!!!! .period.

we warred and freed ourselves from what?? the people of the U.S. are tax abused by its own system nowa days. its a joke and we put up with it toooo long. who gave these savages the authority to cut a laborers feet off for working?!!!! everyone is so bullheaded on avoiding taxes that we ourselves believe we are in the wrong when we “get away with earnings?” its OUR money to begin with!!!! they never helped us earn it!!! and everyone knows taxpayer’s money is improperly used so its stolen for the feeble minded tie bearers lavish lifestyles!!! We have come a long way and we should continue creating a change!!!

I need some assistance not only with my taxes but also with my payroll for my S Corp. I had a friend handling my s corp and for the last two years he stated that I did not have to pay my employees (which is my husband and I) wages. That I can just do a Sch. K-1 at the end of the year with the remainder of the profit left after all the deductions, which is very low so far.

I am now finding out that this is incorrect and for 2008 my taxes were filed with only a K-1 and not W2’s were given or placed on line 7 of the 1120S form.

This will be my 2nd year of doing my taxes for my S corp and I still have not paid any FICA for the year 2009 for my husband and I (employees and officers of the S Corp.).

I need to get my company on track and need someone to assist me with setting up what I need to do so I can pay employee taxes (if not to late for 2009) and if it is too late to at least get it going for 2010. I don’t know what to do at this point and at a loss.

I am hoping that you will be able to assist me with all of this. Can’t we just issue a W2 without any fica/SE/SS deductions on it?
Thank you and look forward to hearing from you.

TOOKIE : If you are paying yourself wages, you will need to take out FICA/SE/SS from the corporate side (and transfer that money to the gov) up to the SS limit. The amount of the check would then only be subject to fed income and state/county…

I’m in the process of forming an s-crop so I was doing some research and came across your blog. 1st spot in google….congrats!

I read all the comments and some of the info is back and forth and opposite. This is why I am glad I have a lawyer and accountant. Yes paying them is a pain BUT the difference in “opinions” here shows that we are NOT experts at this stuff.

If u r LLC and elect for s-corp, can you pay yourself a payroll like a reg s-Corp? I thought LLC couldn’t pay yourself as payroll?

If scorp, is it true u can vary your salary througout the year as long as you don’t go below what thd IRS thinks u should be paying yourself?

Then I heard by the end of the year, you should have zero profit so u dont have to pay franchise excise taxes on what’s left over after paying yourself payroll throughout the year? But doesn’t that deafeat the purpose of paying less SE tax??? If u pay yourself ALL your income, u would have to pay SE tax on all of it correct? If u have any profit left instead, u have to pay Francisr tax? Confused.

Also heard depending on state, you have to pay like $300 year for keeping it alive? Opposed to $20 year for scorp? Seems scorp is best got keeping payroll companies busy even though 1 member scorp? So confused which really is better for 1 person business? LLC or scorp?

Forming a corporation is one of the greatest ways business owners can shield their personal assets. Most individuals choose to incorporate solely for this reason, but there are other advantages as well. For example, a corporation can save you tax dollars, provide greater business flexibility and let you more easily raise capital.

Yes. When it comes to self-employment taxes, S Corporations are better than Limited Liability Companies (LLC’s). It is generally agreed that LLC managing owners must pay self-employment taxes on their share of the LLC’s profits and that can amount to more than 15% of taxable income. But S Corporation shareholders only pay self-employment taxes on compensation they receive in the form of salaries and bonuses, not on their share of the corporation’s profits. This represents an obvious benefit.
And to take even further advantage of this benefit, some S Corporation owners pay themselves salaries that are as low as are reasonable (in the eyes of the IRS), leaving more profits (not subject to self-employment taxes) that are allocated to the shareholders.
Tax issues are very complex so it is always advisable to consult with an expert tax advisor before coming to any final conclusions and in determining what salaries the IRS will consider reasonable.

I have been a biz consultant for more than 20yrs and will say that it is a personal pref. if you want the extra paperwork or not. LLC’s can have the same benifits of S-corp. classified under 8832 form allowing irs to treat llc as s-corp and filing asset protection in the proper mannor will secure your assets. There are no complicated documentation requirements for llc’s and the laws are still under development allowing grandfathered provisions for previously filled llc’s as laws change.

The choice is yours, just make sure you have accurate information. Laws change everyday and no one knows everything however you must be aware of your limitations and know when to ask for help….

If you are an llc and want to change to an s corp please dont forget to file the filing Form 2553 with IRS, signed by all of the shareholders, in order to become an S corporation.

Now, if you are an S-corporation, can you convert it to a C corporation? You can by filing a formal request with IRS, that carries the requirement that you cannot change back to an S corporation for at least five years. You will however be stuck with the December 31 fiscal year, nullifying any ability to use the income shifting tax saving strategy. IRS will not allow you to change your fiscal year because they know that will save you money and that is contrary to their purpose in life. What I have found is that it is much easier to just set up a brand new virgin corporation, especially in states like Arkansas and Missouri where it only costs $50 in filing fees. In states like California, where the filing fees are in the thousands, this strategy is a bit more expensive and needs to be evaluated a little more closely.

In a truck driver in CA that just opened an S Corp and it has been a total disappointment compared to just don’t things as a DBA. Single truck, single owner.

$7,000 in sales
-$2000 in expenses ( tires and truck payment)
I earned $5000 net profit in November
$ 3400 went to my salary or $850/wk
(-$2100) went to CA state and Federal taxes ( ss, med), that’s like 42%
Paid $75 for payroll.

Jonathon, thank you for writing an article on this topic that made sense to me! If possible, can you tell me how to determine my basis in an S-corp if I am the only shareholder who converted it from a sole proprietorship? Since I didn’t pay money to buy the S-corp from a sole proprietor, I don’t know how to determine my basis, as it’s shareholder. Thank you for any advice!

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[…] of them was – what else? – to save some money. I wrote a relatively wordy post a few years back on Forming An S-Corporation To Reduce Self-Employment Taxes. But I just read this e-mail from MyCorporation* that has a concise example with a nifty graphic […]

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